Eric Ervin Eyes Dividends

You can’t fake a dividend, asserts Eric Ervin of Reality Shares, who has developed a series of ETFs based on proprietary dividend models. Here, he discusses the make-up and approach behind these 4 funds.

Steve Halpern: Our special guest today is ETF specialist Eric Ervin of Reality Shares. How are you doing today, Eric?

Eric Ervin: I'm great, thank you for having me.

Steve Halpern: Now, your company focuses on predicting future dividend growth using a proprietary dividend rating system. Could you explain how this works?

Eric Ervin: Sure. We started Reality Shares again with this focus. You know you can't fake a dividend.

A dividend is a window into the earnings growth of a business and really it is true cash that gets returned to the shareholder, so by focusing on the growth of that dividend, what you are ultimately doing is you are focusing on those companies who have the healthiest business models and the ability to grow those earnings.

The problem was that most people as they looked at the growers, what they were doing was they were just looking in a rear view mirror and saying which companies grew their dividends the most and that's really where that whole system breaks down.

Just because a company increased its dividends a lot in the past doesn't mean they are going to increase their dividends in the future.

What we went into was which factors can actually derive a healthy company versus a low quality business and which companies are more likely to increase versus cut.

We named the system DIVCON as in dividend condition just like the DEFCON system, and we break it down in from five, four, three, two, one, one being the worst business.

“One” is most likely to cut and DIVCON “five” is a company who is most likely to increase their dividends.

Steve Halpern: Now, your firm currently offers four dividend-based strategy ETFs. I would like to walk through each of them and perhaps you can then explain the specific goals of each of these ETFs and highlight some stock within each of the funds that meets each of the fund's criteria. Let's begin with Reality Share DIVS ETF (DIVY).

Eric Ervin: DIVY was very innovative. It is the first fund that we ever launched and really kind of our keystone fund from the launch of the firm.

DIVY does something that is very unique in that it accesses the dividend growth rate of the SMP 500.

What DIVY is seeking to do is to invest in securities that actually track the growth rate of dividends without having to worry about a lot of the stock market volatility and stock market noise that go along with equity investing.

Again, DIVY is just based on capturing the growth rate of dividends. If you look back at the S&P 500 for example, dividends have risen 40 out of the last 43 years, so it's really very, very stable.

Again, with that, as you get more stability, you get less overall returns so you end up with a return stream that is a bit more like something you can kind of count on from an absolute return standpoint, 3% to 6% better than say T-bills, for example, so a good bond alternative or alternative to fixed income type investments.

Steve Halpern: Now, you also offer the DIVCON Leaders Dividend ETF (LEAD). Can you tell us about this one?

Eric Ervin: Sure, so the other three funds that we offer are based on this DIVCON system.

That is the system I mentioned earlier where we are going in and we are analyzing business based on these seven different factors and which companies are more likely to increase their dividends in the next 12 months or which companies are most likely to cut their dividends.

The DIVCON Leader ETFs are based on those companies, those leading companies, those are the ones that are most likely to increase their dividends over the next 12 months.

That is based on an index, the Reality Shares DIVCON leader's index, which is like over the past 15 or 16 years been made up of companies with almost 96% increases in the next 12 months and no cuts over that same timeframe.

It's a very high quality type of a business. Even through 2008, there were no cuts in that portfolio.

Steve Halpern: Could you give us an example of a company that would meet the criteria?

These are more that high-quality business that has the ability to grow the dividend, because that's what we found, is the ability to grow the dividend is far more important than the high yield that a company might offer.

In a high yield situation, you might get that melting ice cube, you know where the company is paying out all of its free cash and it doesn't have the ability to withstand market upsets or turmoil. Tyson Foods is a great example of this.

Southwest Airlines (LUV) another good one. Nike (NKE) is really another strong company that has been in the DIVCON Leaders index for almost 7 out of the last 15 years.

Steve Halpern: Now, you also offer two additional portfolios, one called the DIVCON Dividend Defender ETF (DFND) and another that is the DIVCON Dividend Guard ETF (GARD). Can you walk us through the makeup of these funds and how they differ?

Eric Ervin: Absolutely. The Defender is based on the concept that even if we're invested in say the most high quality companies that are most likely to grow, such as the leaders.

When markets go down, they might night go down as much, but they're still going to go down. What we were looking for was a way to defend against those big market upsets that might occur or at least seeking to fix that.

That's where this concept if you have a highly predictive system on which companies will cut their dividends, that if you take a long position, you're invested long in those leader companies.

But you take a shorter position in those laggards we call them, but the companies that are most likely to cut their dividend in the next 12 months. Defender is long 75% in the leaders.

It is short 25% in those laggard companies -- companies like, at the moment, Marathon Oil (MRO), FirstEnergy (FE), and Freeport-McMoRan (FCX).

These are companies that obviously had a high degree of their business based on a very cyclical industry either materials or energy and of course fell on hard times last year as the energy market really fell off the cliff.

There is just an inability to pay the dividend or at least continue to increase their dividends in the future.

Steve Halpern: Now, the Dividend Guard ETF; how does that fit into the scenario?

Eric Ervin: GARD is based on that very similar concept, same portfolio, but in this case it's based on the premise that you don't always want to be short the market.

You don't always want to have a small short position however small it may be. Let's face it, stocks generally go up, but there are times when you want to be hedged and so what GARD does is it is like an on/off switch.

GARD will either be fully invested long positions in those leading companies that are most likely to grow the dividends.

But as market volatility starts to increase and it starts to predict more of bearish market, that's when it will take a long and short position and hedge the portfolio more dynamically so it will be long those leading companies and short those lagging companies -- the companies most likely to cut.

It only does this at certain times of high volatility and stress in the market. For the past 15 or 16 years, the GARD index that the fund is based on would have included a short position in 2000 to 2003 and 2008 to 2009 and then again for the last six months or so it had a long and short position.

Steve Halpern: Well, that's a fascinating approach. Our guest is Eric Ervin of Reality Shares. Thank you so much for taking the time today.